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Tax Reporting for Houses of Worship

If the IRS classifies
an organization as a church it
may enjoy several tax-related benefits,
such as an exemption from federal income
tax, exemption from applying for
tax-exempt status, exemption from
unemployment taxes and exemption from
filing certain annual information returns.

The term church is not specifically defined
in the Internal Revenue Code
but is used in a generic sense that
includes all places of worship including
synagogues and mosques. The IRS listed
14 criteria that are important in
deciding whether an organization is a
church. An organization is not required
to meet all of the 14 criteria to be
classified as a church, but the IRS does
not say which ones or how many are
required for the desired classification.

The “corporation
sole” is a legitimate
corporate form that allows a
bona fide religious leader to hold
property and conduct business for the
benefit of a religious organization.
However, the nebulous definition of a
church has led to abuses which earned
the corporation sole a place on the 2005
IRS Dirty Dozen tax scam list.

If a church meets
the five criteria listed in
section 501(c)(3) of the Internal
Revenue Code, it is automatically
considered tax-exempt. Even so, if a
church has unrelated business income,
that income is subject to income tax.

Churches must still
withhold payroll taxes from
the wages of their employees even though
the church is generally exempt from
paying income tax. In addition, there
are special rules regarding the payment
of Social Security and Medicare taxes
for clergy.

Frances E. McNair, CPA, PhD, is a professor of
accounting at Mississippi State
University in Starkville. Her e-mail
address is fmcnair@cobilan.msstate.edu . Charles R. Pryor is a PhD student at Mississippi
State University. His e-mail address
is crp54@msstate.edu .

merica’s tradition of
religious freedom is as old as the country
itself—and results in an incredible diversity of
form and structure among its religions.
Organizations that the IRS classifies as
“churches” may enjoy several tax-related benefits:
They can be exempt from federal income and
unemployment taxes, from applying for tax-exempt
status and from filing certain annual tax
nformation returns. This article examines the
critical definition of a church for tax purposes,
the requirements for tax-exempt status and some of
the most common areas of misreporting by houses of
worship.

Note that the Internal Revenue
Code uses the term church in a generic
sense that includes synagogues, mosques and all
places of worship. Hence, we will use the IRS term
church in a generic sense in this
article.

Defining “Church”

The term
church is found, but not
specifically defined, in the Internal
Revenue Code. The term is not used by
all faiths; however, in an attempt to
make this article easy to read, we use
it in its generic sense as a place of
worship including, for example, mosques
and synagogues.

WHAT IS A “CHURCH”? IRC section 501(c) describes several
organizations that qualify for tax-exempt status,
including churches, but does not provide a precise
definition of a “church.” However, IRS Publication
1828, Tax Guide for Churches and Religious
Organizations, l ists 14 criteria the IRS
considers important in deciding whether an
organization qualifies. They are

A distinct legal existence. A recognized creed and form of
worship. A definite and distinct
ecclesiastical government. A formal code of doctrine and
discipline. A distinct religious history. A membership not associated with any
other church or denomination. An organization of ordained
ministers. Ordained ministers selected after
completing prescribed studies. A literature of its own. Established places of worship. Regular congregations. Regular worship services. Schools for the religious instruction
of the young. Schools for the preparation of
ministers.

There are more than 300,000
congregations in the United States,
including Protestants, Roman Catholics,
Mormons, Jews, Muslims and others.

An
organization is not required to meet all 14
criteria in order to be classified as a church,
but the IRS has been unwilling to say how many
should be met or whether some are more important
than others. Usually, a combination of these
characteristics along with facts and circumstances
is used to determine whether an organization is a
“church” for federal tax purposes. If an
organization is unjustly denied church
classification, its only recourse is in the
courts.

In one case a District Court’s
determination that a family was not a church
appeared to be relying on the 10th, 11th and 12th
criteria. The court ruled that an organization was
not a church if it was not reasonably available to
the public. In other recent cases, the courts used
some of the 14 criteria but the court also showed
that some or even most of the criteria may not
apply to a specific situation.

So how can
an organization be sure it meets the IRS
definition of a “church”? Even though not required
to do so, it may want to apply for an official
ruling of tax-exempt status to ensure all
available benefits accrue to the organization and
its beneficiaries—for instance, that income
related to its exempt purpose is, in fact,
tax-exempt and contributions are generally
tax-deductible. However, the application for
tax-exempt status (form 1023) is not without
costs. A user fee of $500 is required if revenues
are expected to exceed $10,000 annually. Fees
change periodically; see form 8718 for current fee
information.

THE CORPORATION SOLE SCAM In some cases the nebulous IRC definition of
a church has led to shameless tax scams. The
proliferation of one such scam—the corporation
sole—has earned it a place on the IRS 2005 Dirty
Dozen tax scam list. Promoters of this scam often
argue that since neither the tax code nor the
courts have explicitly defined a church, the
taxpayer is free to do it, which affords the
taxpayer the benefits of 501(c)(3) status.

A corporation sole is a legitimate corporate
form, available in 16 states, which may be used by
bona fide religious leaders to hold property and
conduct business for the benefit of a religious
organization. The purpose is to ensure the
continuity of ownership of property dedicated to
the use of a legitimate religious organization.
Revenue ruling 2004-27 makes it clear that a
taxpayer may not use a corporation sole to hide
income or assets or to evade income taxes. In
fact, establishing a corporation sole based on
anything other than a bona fide religious
organization can result in substantial penalties.

Some taxpayers have tried to claim their
family was a church of which they were the head,
and their personal income or assets belong to the
corporation sole, which is tax-exempt. Not only
have the courts consistently found such arguments
to be frivolous, they also have “imposed penalties
for making such arguments, and upheld criminal tax
evasion convictions against those making or
promoting the use of such arrangements.” Tax
preparers also may be found culpable in such a tax
scam. Potential penalties include a per-return
fine of up to $1,000, a lump-sum penalty of up to
$100,000 and up to three years’ imprisonment.
There also is evidence the IRS intends to pursue
perpetrators of this scam: In March 2004 the IRS
issued a press release warning taxpayers to be
wary of the corporate sole scam, and in subsequent
weeks the Department of Justice filed suit against
alleged promoters of the scam in eight states,
demanding among other things that they surrender
their client lists.

TAX-EXEMPT STATUS In order for an organization to qualify for
tax-exempt status, it must meet five general
requirements outlined in IRC section 501(c)(3).
These are

It must be a corporation.
IRC section 501(c)(3) says that a
tax-exempt organization must be a corporation but
IRC regulations do not require an “official”
corporation. According to Treasury regulations
section 1.501(c)(3)-1(b)(2), a church must
describe its activities in articles of
organization, such as a corporate charter, a trust
instrument, articles of associations or any
written instrument by which an organization is
created.

It must be organized and operated
exclusively for religious, educational,
scientific or other charitable purposes.
A “church” must set forth its
tax-exempt purpose in its articles of organization
(or other similar document referred to above). The
exempt purpose may be more specific than those
listed in section 501(c)(3), but it cannot be
broader than those listed. The organization’s
assets must be distributed to another exempt
organization or used for an exempt purpose upon
dissolution. Specific wording that meets the
organizational test can be found in IRS
Publication 557.

The organization also
must be operated primarily for the tax-exempt
purpose. It may engage in income-producing
activities unrelated to the tax-exempt purpose as
long as these activities are not a substantial
part of the organization’s activities, but these
activities are subject to federal tax. The
unrelated business income tax (UBIT) is discussed
in a later section of this article (page 74).

Net earnings may not inure to the
benefit of any private individual or
shareholder. This simply means
that a tax-exempt organization can make payments
to insiders (employees or clergy) or to other
private parties (founders, trustees or
contributors) only if they are for reasonable
compensation for service, for the fair market
value of real or personal property or to further
the tax-exempt purpose. Prohibited transactions
include payment of dividends, unreasonable
compensation and transferring property for less
than fair value.

No substantial part of the
organization’s activity may be attempting to
influence legislation. IRC
section 501(h) prohibits tax-exempt organizations
from engaging in “substantial” efforts to
influence legislation. But what are substantial
efforts? In Seasongood v.
Commissioner , 227 F2nd 907 (6th Cir.
1955), the court set 5% of time and effort as a
benchmark, but in other cases the courts have used
a percentage of the budget. In the Haswell case,
500 F2nd 1133, the court found that using 16% to
17% of the budget was substantial. The IRS has not
set a specific percentage of time, effort or
budget, but says it will consider a number of
factors, including time and expenditures.
According to Publication 1828, a church will be
regarded as “attempting to influence legislation
if it contacts or urges the public to contact
members or employees of a legislative body for the
purpose of proposing, supporting or opposing
legislation or if the organization advocates the
adoption or rejection of the legislation.”
However, the IRS list of activities that should
not jeopardize tax-exempt status in Publication
1828 includes conducting educational meetings,
preparing and distributing educational materials
and considering public policy issues in an
educational manner. Organizations exempt as a
church, auxiliary, etc., may not make the 501(h)
election.

The organization may not intervene in
political campaigns.
Participation in political
activities even to an insubstantial degree can
cause a church to lose its tax-exempt status.
Contributions to political campaigns or public
statements of position made by the organization
are clearly in violation.

Publication 1828
cites certain activities that may not be
prohibited, including voter education activities
conducted in a nonpartisan manner, voter
registration activities and get-out-the-vote
drives. Still, voter education activities that
favor or oppose a candidate or a group of
candidates over the others are prohibited.

Individuals, including clergy, are allowed to
speak for themselves—even on important public
policy issues. But religious leaders cannot make
partisan comments in official publications or at
official functions. A religious body may invite a
candidate to speak at its events as long as it
provides equal opportunity to all candidates
seeking the same office. Here are two examples
from Publication 1828.

Example 1: Minister A is well
known in the community. Candidate T publishes a
full-page ad in the local newspaper listing five
prominent ministers who have personally endorsed
her, including Minister A, who is identified in
the ad as the minister of Church B. The ad says,
“Titles and affiliations of each individual are
provided for identification purposes only.” The ad
was not paid for by the church and the ad is not
in an official publication of the church. Since
the endorsement was made by Minister A in a
personal capacity, the ad does not constitute
campaign intervention by the church.

Example 2: During regular
services of Temple M, Rabbi D’s sermon mentioned
the importance of voting in the upcoming election,
and Rabbi D said, “It is important that you all do
your duty in the election and vote for Candidate
W.” Since Rabbi D’s remarks indicating support for
Candidate W were made during an official service,
they constituted political campaign intervention
attributable to Temple M.

Tax-exempt
status also may be obtained through a tax-exempt
parent organization, provided the parent provides
the IRS with a list of affiliated churches and
religious organizations. An important caveat is
that “religious organizations” other than
“churches” whose annual gross receipts normally
exceed $5,000 generally must apply to the IRS for
recognition of their tax-exempt status. It is
important to distinguish between churches and
other religious organizations because the former
are afforded special tax rules, especially
concerning employment taxes for their clergy.
Religious organizations that are not churches
include nondenominational ministries,
interdenominational and ecumenical organizations
and other entities whose principal purpose is the
study or advancement of religion.

If a
church fails to meet any one of the criteria
required for tax-exempt status by the IRS, it can
lose its tax-exempt status and the organization
and its leaders may incur significant penalties in
the form of excise taxes. It is also vitally
important to understand the limitations of
tax-exempt status even if recognized by the IRS.
Only certain income is exempt from federal income
tax; an organization still may have significant
reporting and taxation obligations, as we shall
soon see.

PENDING LEGISLATION In 2003, Congressman Jones (R-N.C.)
introduced the “Houses of Worship Free Speech
Restoration Act,” whose purpose is to amend the
Internal Revenue Code to protect the religious
free exercise and free speech rights of houses of
worship. If it passes, houses of worship would not
lose their tax-exempt status because of the
content, preparation or presentation of any
homily, sermon, teaching, dialectic or other
presentation made during religious services or
gatherings. Although the bill did not pass in 2003
or 2004, it has been reintroduced in Congress as
HR 235 with 166 supporters.

UNRELATED BUSINESS INCOME TAXES Although most tax-exempt organizations must
file an annual information return (form 990) with
the IRS, churches are explicitly excluded from
this requirement by IRC section 6033. Still, they
may have some potential reporting and taxation
obligations, such as unrelated business income
taxes (UBIT) and employment taxes.

Since
1970 churches have been subject to taxes on any
business income that is not substantially related
to the exempt purposes. Those with unrelated
business gross taxable income of $1,000 or more in
a tax year are required to file Form 990-T,
Exempt Organizations Business Income Tax
Return, for that year. In order to be
classified as an unrelated business activity
generating taxable income, the activity must
constitute a trade or business, be regularly
carried on and not be substantially related to the
church’s exempt purpose. Note that using the
proceeds of the activity for exempt purposes does
not make the activity related to the exempt
purpose. Income from advertising in church
periodicals, magazines, other publications and Web
sites; gaming activities such as pull-tabs and
raffles; sale of merchandise unless substantially
all of the merchandise was donated; and rentals of
parking lots are all income subject to the
unrelated business income tax. Rental of real
property; dividends, interest, annuities and other
investment income unless derived from
debt-financed property; and gains and losses from
the disposition of investment property are not
subject to the unrelated business income tax.

Note that the $1,000 standard is applied to
gross income. So if gross receipts were at least
$1,000 the church must file form 990-T with the
IRS no later than the 15th day of the fifth month
after the organization’s accounting period ends.
This is true even if it had incurred enough
expenses to have no taxable income.

The
income from activities that meet the three
previously mentioned criteria still may not be
subject to tax if “substantially all of the work
in operating the trade or business is performed by
volunteers, the activity is conducted by the
organization primarily for the convenience of its
members or the trade or business involves the
selling of merchandise substantially all of which
was donated” (Publication 1828).

EMPLOYMENT TAXES Even tax-exempt organizations must withhold
income tax from the wages of employees. However,
special rules apply to Social Security and
Medicare taxes for clergy. Because of the
complexity of payroll tax rules, many churches
fail to correctly report payroll taxes. They are
exempt, however, from federal unemployment taxes
on all employees.

Clergy . Ordained,
commissioned or licensed clergy performing
services in the exercise of ministry are treated
differently from other employees by the tax code.
Clergy who are subject to the control of the
religious body are considered employees. Three
unique situations apply to clergy employees.

First, even though clergy may be employees for
federal income tax purposes, they are always
self-employed for Social Security purposes.
One common mistake churches make is to consider a
clergyperson an employee for Social Security tax
purposes, withhold federal income tax and FICA tax
and pay this amount along with the withholdings of
other employees.

Second, an officially
designated housing allowance or the fair rental
value of a home provided to a clergyperson is
excluded from his or her income for income tax
purposes but not for self-employment tax purposes.
The religious body must officially designate the
amount of the housing allowance prior to payment
for such allowance. Generally, the local
congregation is required to make the designation.

Third, a clergyperson’s wages are exempt
from income tax withholding. However, a
clergyperson may enter into a voluntary
withholding agreement with the religious body that
can be terminated at any time by either party. In
this event the religious body may withhold not
only income taxes but also estimated
self-employment taxes. The religious body should
report this amount on form 941 as additional
income taxes withheld and not as Social Security
or Medicare taxes. The amount withheld is then
used as a credit against both the federal income
tax and the self-employment tax on the
clergyperson’s income tax return. Voluntarily
withholding taxes eliminates the need for the
clergyperson to make estimated tax payments and is
considered a timely payment of income tax and
self-employment tax, thus avoiding any
late-payment penalties for quarterly estimated
tax.

The resulting reporting requirements
by religious bodies for clergypersons are as
follows:

W-2s should be provided to
clergypersons and transmitted to the IRS with the
transmittal form W-3 if the clergyperson is
considered an employee for income tax purposes.
Only taxable wages and reimbursements made under a
nonaccountable plan are included in box 1 of the
form W-2. The housing allowance amount is not
included in this box; it is generally reported in
box 14 of the W-2. All of the voluntary
withholding is shown box 2 of the W-2. No amounts
are shown in boxes 3 and 5, Social Security and
Medicare wages.

Practical Tips

The CPA should

Help the
organization determine whether
it is a church or other
religious organization.
Special benefits apply to
churches.

Review the
requirement for tax-exempt
status, and help the church
comply with the requirements.

Be sure any
corporation sole is not
designed to hide assets or
evade income taxes and is for
the benefit of a legitimate
religious organization.

Advise churches
with unrelated business income
to file the proper income tax
returns.

Help churches
file the proper employment tax
returns for ministers and
other employees.

Help churches
file the proper form 1099s for
nonemployees.

Help churches
file other forms when
required: for example,
certificate of racial
nondiscrimination (form 5578)
and written acknowledgement of
contributions.

Help churches
maintain proper records to
support tax-exempt status and
maintain proper books and
records for all required
reporting.

1099s should be provided to
clergypersons who are treated as self-employed for
income tax purposes. However, it should be noted
that in most cases the IRS considers clergypersons
employees for income tax purposes.

Other employees. Religious
institutions are required to withhold income taxes
from the wages of nonclergy employees just as for
any other employer. They are required to withhold
Social Security and Medicare taxes for any
employee paid $108.28 or more during the calendar
year and to pay the employer’s portion of these
taxes unless they receive a special exemption.

The Tax Reform Act of 1984 allows a
religious body to elect a special exemption from
the employer’s share of FICA taxes if it opposes
such taxes on religious grounds. The election, on
form 8274, must be made by the day before the due
date of the first required form 941. Since
clergyperson’s wages are not subject to
withholding for either income tax or FICA, the
deadline can expire only if there is at least one
nonclergy employee. The IRS does not allow
exceptions to this deadline. If a religious body
elects this exemption in a timely manner then all
its employees are treated as self-employed for
Social Security and Medicare tax purposes; the
employees must pay the self-employment tax and
will normally have to make estimated tax payments.

Nonemployees . Payment of
$600 or more in a calendar year by any “person
engaged in a trade or business” to any nonemployee
or partnership (not a corporation) in furtherance
of that trade or business requires the filing of a
form 1099-MISC. What about recipients of
benevolent gifts from the church? Are these
amounts to be reported on 1099s? According to
revenue ruling 2003-12, to the extent the
distribution is consistent with the tax-exempt
purpose, a 1099 is not required. These recipients
have performed no service.

To assess
whether a person is an employee or nonemployee,
the tax preparer can use IRS Publication 15-A,
Employer’s Supplemental Tax Guide, or file form SS-8
to have the IRS make the determination. While the
IRS maintains that substantial penalties may be
assessed against organizations that fail to
properly withhold employment taxes, section 530 of
the Revenue Act of 1978 provides considerable
protection for the organization against excessive
penalties. However, these protections do not
extend to the workers. A member of the clergy who
improperly reports earnings as self-employed
earnings may face considerable penalties if the
IRS subsequently reclassifies him or her as an
employee.

OTHER REPORTING REQUIREMENTS Religious bodies that operate, supervise or
control a private school including a preschool or
kindergarten, must file a certificate of racial
nondiscrimination, form 5578, each year with the
IRS. This is required only if the organization
doesn’t file a form 990.

Donors should
receive written acknowledgement of any
contribution of $250 or more and any quid pro quo
contributions in which the donor received goods or
services in exchange for contributions of $75 or
more in order for them to deduct the contribution
on their tax returns. On the quid pro quo
contribution, the donor may deduct only the amount
of the contribution that is in excess of the fair
value of any goods or services received, unless
the goods or services were of insubstantial value
or of only intangible religious benefit. A ticket
to a prayer meeting is of intangible value; a
ticket to the Super Bowl is not.

All
tax-exempt organizations, whether officially
recognized or not, are required to maintain
records of employees and donors, books of
accounting and other records necessary to justify
their claim for exemption in the event of an audit
or to accurately file federal tax and information
returns. The organization must keep all employment
tax records for at least four years after the date
the tax is due or is paid, whichever is later.
Generally, records that support an item, income or
deduction must be kept for three years from the
return filing date or tax payment date, whichever
is later. If unreported income is more than 25% of
the gross income, the period becomes six years. If
there is fraud involved or if no required return
is filed, there is no statute of limitations.

Roseview
Church is a small but well-established
church located in an urban area. It has
one minister and one other employee. It
also paid $50 per week to Jane Jones for
custodial services. Its operating funds
are generated primarily from donations
from its congregation and the community.
However, it does rent its parking lot on
weekdays to a neighboring business. The
following selected annual financial
information is available:

Salary
of minister ($3,000 monthly)

$36,000

Housing allowance for
minister

24,000

Salary paid to
church administrative assistant

26,000

Payments to Jane Jones (52 x
$50)

2,600

Rental income from
parking lot

6,000

Reporting requirements for the above:

Minister: The
minister is considered self-employed and
is not subject to any withholding
requirements. However, the minister and
the church have entered into a voluntary
withholding agreement. The church
withholds $400 per month in withholding
taxes. The amount is remitted quarterly
or monthly along with payroll taxes of
the other employee. The church is
required to furnish the minister with a
W-2 and transmit it to the IRS with the
W-3. The minister’s W-2 will report the
following:

Box 1,
Taxable wages

$36,000

Box 2, Federal
income tax withholding

4,800

Box 3, Social Security wages

0

Box 14, Other income:
Housing allowance

24,000

Other employee(s):
The other employee is
subject to FICA and federal income tax
withholding. The amounts withheld, along
with the church’s part of the FICA tax,
are paid monthly and reported quarterly
to the IRS on form 941.

Neither
the salaries of the minister nor the
other employee are subject to
unemployment taxes.

Independent contractor:
Ms. Jones is considered an
independent contractor because she
chooses her own hours and uses her own
equipment. The church must furnish Ms.
Jones a form 1099 by February 1 for her
services for the prior year. This amount
also is reported to the IRS along with
form 1096 by March 1.

Because
the church has unrelated business
income, it must file a federal income
tax return. It will file Form 990-T,
Exempt Organizations Business
Income Tax Return, and report
income of $6,000. The church also may
deduct a portion of any parking lot
expenses on the tax return.

One
other important requirement: The church
should keep a record of the
contributions and furnish its donors
with proper documentation. The written
statement should include the following:

Name of the church or
religious organization.

Date of the contribution.

Amount of any cash
contribution.

Description of any noncash
contribution.

A statement that no goods
or services were provided by the church
or religious organization in return for
the contribution.

Or a statement that goods
and services that a church or religious
organizations provided in return for the
contributions consisted entirely of
intangible religious benefits.

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